This week, USA Today came out with an article on how more money poured into stock mutual funds in the last week than any other week in the last eleven years. Now at first glance that may come as good news as investor confidence seems to be returning in the wake of a resolution to the fiscal cliff dilemma, but before you jump on the stock market bandwagon, remember the words of renowned investor Warren Buffett. When asked about his philosophy on investing, he is known to have said he is greedy when others are fearful, and fearful when others are greedy. In other words, Warren Buffett, one of the greatest investors of all time, has a tendency to go against the flow when it comes to investment decisions.
So with that in mind, I’d like to caution you against getting too comfortable with investing in the stock market. It’s not that I believe the stock market is a bad place to invest, but rather I know from history how the stock market behaves, and this wouldn’t be the first time that investors got excited about investing only to end up hurting themselves if and when the market has a correction. Before you begin allocating more money into stocks, do the following three things:
1. Assess your financial goals
Stocks are intended to be long-term investments, so unless you realistically have ten or more years until you plan to spend your money, you may want to consider some other options that may be more appropriate for your time horizon. For example, money you plan to spend within the next three to five years you may just want to keep in cash using a CD, a money market fund, or short-term treasury bonds. For money that you will spend in the next five to ten years, you may want to try an intermediate investment, such as a corporate bond or other more conservative options, though I’d be careful with bond mutual funds as they could actually lose value if inflation and interest rates increase over that period of time.
2. Assess your risk tolerance
Sure, the stock market is going up now, but don’t expect things to move in a straight line. As my friend and colleague, Diane Winland, has said to me on many occasions, the market does not like uncertainty, and there is plenty of uncertainty down the road, including a soon-to-be congressional fight over raising the debt ceiling. As a result, expect some market volatility that may be too much for more conservative investors. Take a risk tolerance survey to determine what your true risk tolerance is, and use that, and not current market performance, as a gauge for how much to invest in the stock market.
3. Assess your options
If you are going to allocate more money to the stock market, consider diversifying among the different types of stocks. Small cap stocks have historically outperformed large cap stocks over long periods of time, but with more volatility in the short term. Value stocks tend to be more stable than growth stocks in times of uncertainty. It would also be wise to have exposure to investments outside of this country, just in case the U.S. economy hits a bump in the road along the way. It’s also a good idea to hedge your bets with some exposure to real estate, commodities, or other similar assets.
Mutual funds are a popular way to invest in the stock market, and sometimes the only way in a 401(k) account, but if you are using a taxable account and want to limit your downside without watching the market regularly, consider ETFs or buying individual stocks. These instruments allow you to place stop-loss orders that automatically sell your position when the price drops below a certain point. If the market keeps going up, you can raise your stop limit as a way of locking in the increase, but if the market suddenly drops, you can protect yourself from experiencing more losses than you are willing to accept.
Warren Buffett also believes that it is important to invest in what you know, so if deciding how much to invest in stocks and bonds and large caps and small caps and real estate and commodities is more than you are comfortable with, consider using a target-date or asset-allocation fund that pre-selects your investments based on your time horizon and/or risk tolerance. You could also work with an investment professional that can help you to understand your options. The bottom line is this: don’t let what everyone else is doing be the reason why you do what you do. After all, it’s not their money.